Why the Auto Industry Is On the Brink of a Decline

Dealers are offering the biggest discounts since the Great Recession, and a combination of historically low gas prices and improvements in fuel efficiency mean consumers can upgrade from cars to SUVs without forking over a huge chunk of their paycheck to gas stations each month.

But the story is entirely different for U.S. carmakers and dealers. Although the auto industry has enjoyed record sales recently, there are early signs that the party could soon be over.

And that could spell trouble for President Trump’s economic agenda. Although he has celebrated automakersGeneral Motors, Fiat Chrysler, Ford, and Toyota for announcing new jobs at U.S. factories, these manufacturers could soon be caught in a bit of a contradiction, with weaker earnings ahead leading to furloughs or even job cuts if they’re forced to cut production.

Broadly speaking, autos make up about 3% of the country’s gross domestic product, but account for a slightly larger share of inflation metrics like the Consumer Price Index and the Fed’s preferred measure of prices, known as personal consumption expenditures.

This may sound small, but it’s enough for a steep decline in the auto sector to shave a few tenths from both GDP and the inflation metrics, limiting Trump’s ability to reach the rapid economic growth he has promised and hampering the Federal Reserve’s target for 2% inflation.

Here’s how it could play out.

We’re at peak auto sales: The auto industry has enjoyed a boom over the last few years. Vehicle sales hit records in 2015 and 2016, as more jobs, rising wages, low interest rates and historically low gasoline prices fueled consumers to replace older vehicles and upgrade from cars to SUVs. Meanwhile, a recovery in the housing market boosted sales of pickup trucks.

But now industry experts say they’ve reached the peak and there’s nowhere to go but down. Speaking Tuesday at a forum ahead of the New York International Auto Show, a Toyota executive admitted as much, forecasting U.S. sales for the entire industry will decline to between 17 million and 17.2 million units in 2017, down from a record high of 17.5 million the year before.

Toyota certainly isn’t alone. Dealers are having to offer consumers the biggest discounts since the Great Recession to move new cars off the lots. These discounts averaged about $3,900 per vehicle in the first three months of 2017, or about 10.5% of the average manufacturer’s suggested retail price (MSRP) for a new vehicle, notes J.D. Power forecaster Thomas King.

“The industry is using tactics to maintain their sales pace, which is creating challenges,” he told Fortune. “There’s a risk of a hangover to come.”

There’s a glut of both new and used cars. Part of the reason why dealers are offering such deep discounts is because they’re producing more cars than there is demand. After record sales for two years running, there’s less appetite from consumers to replace older vehicles.

In addition, dealers selling new cars are facing increased competition from used vehicles. During a weak job market in the recession, drivers held on to their cars for longer than usual, meaning that there were fewer used vehicles on the market and prices climbed to record highs. But now those used vehicles are coming back on to the market, driving the prices down.

Dealers selling new cars have to compete with some pretty amazing deals on gently used vehicles.

“If you were shopping for a vehicle, and you happen to look at the used vehicle lot, you’re going to see a much bigger selection of nice used vehicles,” King said.

What’s more, this slump in used vehicle prices hurts consumers who want to trade in their older models. As used vehicles depreciate faster, car buyers will find they have less equity than they may have expected when turning in an older vehicle.

Longer loans, the Fed’s rate hikes and rising delinquencies will all squeeze automakers’ profit margins. In the first quarter, more than a third of new auto loans were dated 72 months or longer. Consumers are locking in these six-year loans to get lower monthly payments, and as a result are choosing to buy more expensive vehicles with more features. A lot can change in the economy, not to mention an individual’s personal finances over a period of six years or more, and it could be argued that many buyers are spending more than they can afford.

These longer loan durations are increasing the risk of defaults, and already the Federal Reserve Bank of New York data show new delinquencies are back at their highest levels since 2008.

Higher delinquencies can foreshadow losses for carmakers and financiers, who have recently made 0% financing a widespread phenomenon. Delinquencies and interest rate hikes from the Federal Reserve will further squeeze automakers’ profit margins, limiting their ability to keep offering deep discounts to customers.

Finally, automakers and dealers are left with just two choices: Either cut production or introduce even steeper discounts to keep selling record numbers of vehicles.

Over the short-term, this mix of strategies could keep auto sales stable around their latest record highs, but not without posing longterm consequences on the industry.

“The pieces of the puzzle are coming together to point to weakness ahead for the auto sector, but there is the lingering question of how quickly the story will evolve,” Bank of America Merrill Lynch economists Michelle Meyer and Alexander Lin wrote in a recent note to clients, aptly titled: “Are we heading into a car crash?”

The answer? Not yet, but stay tuned.

“So far, the slowdown in the pace of auto sales is manageable for the economy,” they concluded.

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